Do robo-advisors represent a market risk? SEC flags concerns about their performance in the face of market instability
The SEC and Nasdaq have flagged concerns that robo-advisors , whose ability to roll with financial crises and other causes of volatility is untested, could become a source of risk for the financial markets.
The robo-advisor business, which is hugely popular with Millennials, is forecast to grow to a market worth US$285 billion this year. No-one can refute the possibility that the danger of insufficiently well-thought-through investment that lurks behind the informal, easy, uncomplicated small-scale investment robo-advisor concept could deal decisive blows to the financial markets.
The adverse impact of easy investment without a clear understanding of the risks
The robo-advisor business has established a new asset management model based on the concept that anyone can enjoy investing their money in an informal, easy and uncomplicated manner. Simply by inputting a few personal details and selecting your level of risk tolerance, a robo-advisor will automatically create your optimum portfolio and manage your assets for you.
Through the use of technology and an all-inclusive approach, the robo-advisor business has created a buzz around digital investment, especially among Millennials, and the total value of assets managed globally by robo-advisors is forecast to reach US$285 billion before the end of the year according to Aite Group data.
The fact that people can try investing with relatively small sums means that the business has created an environment in which complete beginners with no investment knowledge whatsoever can start making investments without doing any preparatory research at all. It is hardly surprising that there is danger lurking behind the jolly façade. We need to acknowledge the concerns expressed in some quarters that the robo-advisor business could have downsides for both investors and markets.
Can robo-advisor algorithms respond to financial instability?
In February, the SEC urged investors to make sure they ascertain upon what investment criteria and data robo-advisors base their investment advice.
In March 2016, Nasdaq flagged the fact that robo-advisors are not advisors but online software based on algorithms, and that the key risk is the lack of transparency.
Robo-advisors have not been around very long, and are untested in the face of financial instability. We have absolutely no idea at the moment how well they can stand up to risk. And we all remember that Wall Street’s vaunted risk models (algorithms) have generated US$22 trillion in losses since the crisis of 2008.
The implied equation that technology and algorithms equals safety and certainty simply does not stand in the world of investment. No-one right now can predict how robo-advisors would read and respond to a Lehman-magnitude collapse risk. Many of the algorithms used by robo-advisors look too simplistic to seasoned investors.
Software developed by programmers, not investment advisors
Furthermore, there is the issue of where responsibility lies. We are witnessing a debate about where responsibility lies should a self-driving car (being developed by the likes of Google and Apple) be involved in an accident, and there are similar doubts about the locus of responsibility for robo-advisors.
Who would be responsible if an investor using a robo-advisor sustained a serious loss? Are investors investing entirely at their own risk, or does the company operating the robo-advisor bear some of the responsibility, or is it down to programming errors by the software developer?
Robo-advisory businesses have to be registered with the SEC, but as it is the programmer who develops the software, it is not held to the same standards as regular Registered Investment Advisors (RIA).
There are doubts about how many software developers there are who have a wealth of investment experience. Is it not a strange thing to place one’s faith in software developed by people who have next to no experience of investment, albeit that they are well-versed in technology?
Are robo-advisors ill-suited for long-term investment?
Another concern is the lack of transparency regarding costs. The robo-advisor business markets itself as low-cost, but it is not unusual for the final cost to be higher than anticipated, as individual companies levy various additional charges, such as commission, currency conversion fees, transaction fees and custodian fees.
Whilst using a robo-advisor is definitely still cheaper than using a RIA, some argue that using an ETF (exchange traded fund) investment advice service is cheaper overall, with the added benefit that you can, if necessary, consult an actual human advisor.
According to LIMRA 2015 data, there is significant disparity in the level of robo-advisor use between the generations: whilst 11% of generation Y (those born between 1980 and 1999) have used a robo-advisor, only 7% of generation X (born 1960-1979) and a mere 1% of babyboomers (born 1945-1959) have done so.
This makes it clear that it is the generation born in the digital era that are the core customer base for robo-advisor business, but their youth suggests that they may not have acquired enough investment experience to make cool and rational investment decisions rooted in a sufficient understanding of the data.
US independent financial planner Matt Logan doubts that robo-advisors are suited to long-term investment, as he perceives that robo-advisor customers tend to be swayed by market volatility and to make overhasty decisions. Perhaps the best strategy for now is to use robo-advisors and actual financial planners for different strands of your investment, or to use them in parallel, depending on your individual investment style.